Financial Markets and International Capital Flows

1. Financial Markets and International Capital Flows

2. Introduction • The stock market boom included sound investment decisions and speculation (gambling). • The role of financial markets is to ensure national saving is allocated to the most productive uses. Chapter 24: Financial Markets and International Capital Flows

3. The Financial System and theAllocation of Saving to Productive Uses • Key Components of Economic Growth • High rates of savings • An efficient financial system that distributes national savings to the most productive investments • The U.S. financial system: • Is a decentralized market oriented system. • Includes financial institutions and financial markets. Chapter 24: Financial Markets and International Capital Flows

4. The Financial System and theAllocation of Savingsto Productive Uses • The financial system in the U.S. improves the allocation of savings in two ways: • Provides information • Helps savers share the risk Chapter 24: Financial Markets and International Capital Flows

5. The Financial System and theAllocation of Savingsto Productive Uses • The Banking System • Banks are a financial intermediary between savers and borrowers. • By acting as a financial intermediary, banks can increase the efficiency of the capital market in several ways: • Banks specialize in evaluating the quality of a borrower and perform the task at a lower cost. Chapter 24: Financial Markets and International Capital Flows

6. The Financial System and theAllocation of Savingsto Productive Uses • The Banking System • By acting as a financial intermediary, banks can increase the efficiency of the capital market in several ways: • Banks pool savings, which increases the efficiency of making large loans. • Banks develop expertise in making small business and consumer loans. • Banks offer services to savers which attract their deposits. Chapter 24: Financial Markets and International Capital Flows

7. The Financial System and theAllocation of Savingsto Productive Uses • Economic Naturalist • How has the banking crisis in Japan affected the Japanese economy? • 1980s • Japanese banks made loans in the bullish real estate market and acquired stock in corporations. Chapter 24: Financial Markets and International Capital Flows

8. The Financial System and theAllocation of Savingsto Productive Uses • Economic Naturalist • 1990s • Real estate prices plummeted and many borrowers defaulted on their loans. • Falling stock prices reduced the value of the banks’ shareholdings • “Credit crunch” occurred and small businesses could not get loans • Japan fell into a severe recession Chapter 24: Financial Markets and International Capital Flows

9. The Financial System and theAllocation of Savingsto Productive Uses • Bond • A legal promise to repay a debt, usually including both the principal amount and regular interest payments • Principal Amount • The amount originally lent • Coupon Rate • The interest rate promised when a bond is issued Chapter 24: Financial Markets and International Capital Flows

10. The Financial System and theAllocation of Savingsto Productive Uses • Coupon Payments • Regular interest payments made to the bondholder • Bonds -- An Example • Principle amount of a bond = $1,000,000 • Coupon rate = 5% • Annual coupon payment = (0.05)($1,000,000) = $50,000 Chapter 24: Financial Markets and International Capital Flows

11. The Financial System and theAllocation of Savingsto Productive Uses • Bonds • Corporations and governments sell bonds to raise funds. • The longer the term of the bond the higher the coupon rate. • The greater the risk of default, the higher the coupon rate. • Municipal bonds are exempt from federal taxes and have a lower coupon rate. • Bondholders may sell their bonds at any time in the bond market at their market price. Chapter 24: Financial Markets and International Capital Flows

12. The Financial System and theAllocation of Savingsto Productive Uses • Example • Bond prices and interest rates • Jan 1, 2003 purchase a 2 year government bond • Principle amount = $1,000 • Coupon rate = 0.05 • Coupon payment = $1,000 x 0.05 = $50 (Jan 1, 2004) • At maturity: $1,000 + $50 = $1,050 (Jan 1, 2005) Chapter 24: Financial Markets and International Capital Flows

13. The Financial System and theAllocation of Savingsto Productive Uses • Example • Bond prices and interest rates • Want to sell the bond on Jan 1, 2004 The prevailing interest rate = 6% Bond price x 1.06 = $1,050 Bond price = $1,050/1.06 = $991 The prevailing interest rate = 4% Bond price = $1,050/1.04 = $1,010 • Observation • Bond prices and interest rates are inversely related Chapter 24: Financial Markets and International Capital Flows

14. The Financial System and theAllocation of Savingsto Productive Uses • Stock (or equity) • A claim to partial ownership of a firm • Two sources of return to stockholders • Dividend • A regular payment received by stockholders for each share that they own • Capital gain • The difference between the purchase price and selling price, when the selling price is higher Chapter 24: Financial Markets and International Capital Flows

15. The Financial System and theAllocation of Savingsto Productive Uses • Example • How much should you pay for a share of FortuneCookie.com • Dividend = $1.00/share in one year • Price/share = $80 in one year • Each share will be worth $81 in one year • Rate of return = 6% • Stock price x 1.06 = $81 • Stock price = $81/1.06 = $76.42 • If dividend = $5, stock price = $85/1.06 = $80.19 Chapter 24: Financial Markets and International Capital Flows

16. The Financial System and theAllocation of Savingsto Productive Uses • Observations • An increase in future dividends or future stock prices will raise the price of the stock today. • An increase in required rate of return will lower today’s stock price. • The uncertainty of future earnings and dividends increases the risk of purchasing a stock. • Stock market investors account for this risk by requiring a higher rate of return or risk premium. Chapter 24: Financial Markets and International Capital Flows

17. Economic Naturalist Why did the U.S. stock market rise sharply in the 1990s, then fall in the new millennium? During the 1990s boom: Economic growth fueled expectations of higher dividends Diversification reduced the risk premium Bond Markets, Stock Markets, and the Allocation of Savings Chapter 24: Financial Markets and International Capital Flows

18. Economic Naturalist The millennium decline Tech failures and scandals lowered the dividend expectations. Risk premium rose in response to the recession, terrorist attacks, and corporate scandals. Bond Markets, Stock Markets, and the Allocation of Savings Chapter 24: Financial Markets and International Capital Flows

19. International Capital Flows • Two Macroeconomic Roles for International Capital Flows • A country with greater investment opportunities than savings can fill the savings gap by borrowing from abroad. • International capital flows allow countries to run trade imbalances. Chapter 24: Financial Markets and International Capital Flows

20. International Capital Flows • International financial markets allocate savings to productive capital in different countries. • International financial markets are subject to the laws of at least two countries. • International Capital Flows • Purchases or sales of real and financial assets across international borders Chapter 24: Financial Markets and International Capital Flows

21. International Capital Flows • International Capital Flows • Purchases or sales of real and financial assets across international borders • Capital Inflows • Purchases of domestic assets by foreign households and firms • Capital Outflows • Purchases of foreign assets by domestic households and firms Chapter 24: Financial Markets and International Capital Flows

22. International Capital Flows • Trade Balance (or net exports) • The value of a country’s exports less the value of its imports in a particular period (quarter or year) Chapter 24: Financial Markets and International Capital Flows

23. International Capital Flows • Trade Surplus • When exports exceed imports, the difference between the value of a country’s exports and the value of its imports in a given period • Trade Deficit • When imports exceed exports, the difference between the value of a country’s imports and the value of its exports in a given period Chapter 24: Financial Markets and International Capital Flows

24. The U.S. TradeBalance, 1960 - 2001 • Observations • Trade has become increasingly important • Since the 1970s, the U.S. has run trade deficits Chapter 24: Financial Markets and International Capital Flows

25. International Capital Flows • Trade balance • Difference between the value of goods and services exported and imported • Net Capital Flows • Difference between purchases of domestic assets by foreigners and the purchase of foreign assets by domestic residents Chapter 24: Financial Markets and International Capital Flows

26. International Capital Flows • Capital Flows and the Balance of Trade • NX = trade balance (net exports) • KI = net capital inflows • NX + KI = 0 Chapter 24: Financial Markets and International Capital Flows

27. International Capital Flows • Understanding NX + KI = 0 • U.S. resident buys a $20,000 Japanese automobile • The Japanese car manufacturer receives $20,000 and has two options • He can buy $20,000 of U.S. goods • U.S. exports = imports or NX = 0 and KI = 0 • NX + KI = 0 Chapter 24: Financial Markets and International Capital Flows

28. International Capital Flows • Understanding NX + KI = 0 • U.S. resident buys $20,000 Japanese automobile • The Japanese car manufacturer has $20,000 and has two options • He can buy U.S. assets (land, bond, etc.) • NX = -$20,000 • Capital inflow = KI = $20,000 • NX (-$20,000) + KI ($20,000) = 0 Chapter 24: Financial Markets and International Capital Flows

29. International Capital Flows • The Determinants of International Capital Flows • Real interest rate • High domestic real interest rates will cause net capital inflows. • Low domestic real interest rates will cause net capital outflows. Chapter 24: Financial Markets and International Capital Flows

30. Net capital inflows, KI KI < 0 Net capital outflows KI > 0 Net capital inflows 0 Net Capital Inflows and The Real Interest Rate Domestic real interest rate r Net capital inflow KI Chapter 24: Financial Markets and International Capital Flows

31. International Capital Flows • Risk • For a given real interest rate, an increase in riskiness in domestic assets will reduce net capital inflows and vice versa Chapter 24: Financial Markets and International Capital Flows

32. KI’ Increases in risk reduces the willingness of foreign and domestic savers to hold domestic assets. An Increase In Risk Reduces Net Capital Inflows KI Domestic real interest rate r 0 Net capital inflow KI Chapter 24: Financial Markets and International Capital Flows

33. International Capital Flows • Savings, Investments, and Capital Inflows • Y = C + I + G + NX • Subtract C + G + NX from both sides • Y - C - G - NX = I • National saving (S) = Y - C - G • NX + KI = 0; so, KI = -NX • Substitute S for Y - C - G & KI for -NX • S + KI = I Chapter 24: Financial Markets and International Capital Flows

34. International Capital Flows • Observation • The pool of savingsavailable for domestic investment includes national savings and the funds from savers abroad. Chapter 24: Financial Markets and International Capital Flows

35. S S + KI • I = demand for capital investment funds • S + KI = total supply of savings • S = domestic supply of savings • r*= equilibrium real interest rate E r* I The Savings-Investment Diagram For An Open Economy Real interest rate (%) Savingsand investments Chapter 24: Financial Markets and International Capital Flows

36. S S + KI • Observations • For high r, KI are positive and S + KI is to the right of S • For low r, KI are negative and S + KI is to the left of S • At low r, net savingsis reduced in an open economy E r* I The Saving-Investment Diagram For An Open Economy Real interest rate (%) Savingsand investments Chapter 24: Financial Markets and International Capital Flows

37. International Capital Flows • Observations • A country that attracts foreign capital will have lower real interest and higher investment. • Countries with a stable political environment and well defined property rights will attract more foreign capital. Chapter 24: Financial Markets and International Capital Flows

38. International Capital Flows • Economic Naturalist • Why did the Argentine economy collapse in 2001 - 2002? • The SavingsRate and the Trade Deficit • A low rate of national savingsis the primary cause of trade deficits. Chapter 24: Financial Markets and International Capital Flows

39. International Capital Flows • The SavingsRate and the Trade Deficit • Y = C + I + G + NX • Subtracting C + I + G from both sides • Y - C - I - G = NX • S = Y - C - G • S - I = NX • Assuming I is constant • If S increases, NX increases, and vice versa. Chapter 24: Financial Markets and International Capital Flows

40. International Capital Flows • The SavingsRate and the Trade Deficit • Low national savings imply high consumer and government spending • High rates of spending will: • Increase imports. • Decrease exports. Chapter 24: Financial Markets and International Capital Flows

41. International Capital Flows • The SavingsRate and the Trade Deficit • Low national saving will also increase capital inflows. • High spending creates investment opportunities • Shortage of domestic saving will occur • Real interest rates will rise • Capital inflows will occur Chapter 24: Financial Markets and International Capital Flows

42. National Savings, Investments, and the Trade Balance in the U.S., 1960 - 2001 • Why is the U.S. trade deficit so large? • Is the U.S. trade deficit a problem? Chapter 24: Financial Markets and International Capital Flows

43. FDI Inflow per GDP in Groups, % Source: WDI 2017 Chapter 24: Financial Markets and International Capital Flows

44. FDI Inflow per GDP in Advanced Countries, % Source: WDI 2017 Chapter 24: Financial Markets and International Capital Flows

45. FDI Outflow per GDP in Groups, % Source: WDI 2017 Chapter 24: Financial Markets and International Capital Flows

46. FDI Outflow per GDP in Advanced Countries, % Source: WDI 2017 Chapter 24: Financial Markets and International Capital Flows